North American Free Trade Agreement (NAFTA)

What it is:

The North American Free Trade Agreement (NAFTA) is an agreement among the United States, Canada and Mexico designed to remove tariff barriers between the three countries.

How it works (Example):

NAFTA was implemented on January 1, 1994, and supersedes the U.S.-Canada Free-Trade Agreement (CFTA) that took effect on January 1, 1989.

A tariff is a federal tax on imports or exports. NAFTA required the elimination of tariffs on half of U.S. goods shipped to Mexico and the gradual phase out of other tariffs among the U.S., Canada and Mexico over a 14-year period.

Because tariffs make it more expensive for consumers to purchase foreign goods, imports tend to decline when tariffs are high, which in turn causes a decline in the supply of the good and an increase in the price of the good. The price increase usually motivates domestic producers to increase their output of the product.

For example, let's assume Company XYZ produces cheese in Scotland and exports it to the U.S. The cheese costs $100 per pound but is subject to a 20% ad valorem tariff placed on the cheese by the U.S., which forces Company XYZ to pay the U.S. government an extra $20 to export it. Company XYZ would presumably mark the price of the cheese up to at least $120 in order to recover the cost of the tariff.

Under NAFTA, if the exporting and importing takes place within Canada, the United States and Mexico, the cheese would be subject to a much lower (or even no) tariff, presumably making the cheese cheaper than a Scottish import.

Why it Matters:

NAFTA is essentially a tariff agreement designed to facilitate trade and ensure that North American producers receive preferences over goods not originating in the U.S., Canada or Mexico. According to the International Monetary Fund, trade among the three NAFTA countries more than tripled between 1993 and 2007.

But NAFTA is also highly controversial. Some economists and policy analysts argue that tariffs interfere with free market ideals by diverting resources to industries in which the U.S. is a less efficient, high-cost producer. Another common argument is that NAFTA encourages companies to outsource American jobs to lower-cost countries and the loss of tariffs reduces the money available for government programs.

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